Mutual Funds and Investment Products: NAV, Types and SIP

A mutual fund collects money from a large number of investors, puts it into shares, bonds and other securities through a professional fund manager, and gives each investor units that represent a share of the pool. Banking and economy papers ask who regulates mutual funds, how the net asset value is worked out, what the three-tier structure of a fund in India is, and how the common investment products differ from one another. These notes cover all of that, along with the other savings and investment instruments an aspirant should be able to tell apart.

What a mutual fund is and how its value is measured

A mutual fund is a vehicle for pooled investment. Because the pool is large, a small investor gets professional management, diversification across many securities and liquidity that direct investment in a single share cannot give. The worth of one unit is the net asset value, or NAV, which is the market value of all the assets of the scheme minus its liabilities, divided by the number of units outstanding; it is declared at the end of each working day for an open-ended scheme. The expenses of running the scheme are recovered as the total expense ratio, which the Securities and Exchange Board of India caps, and an investor who leaves early may pay an exit load. A direct plan, bought from the fund house itself, has a lower expense ratio than a regular plan bought through a distributor, because no commission is paid.

The three-tier structure and the regulator

A mutual fund in India is set up as a trust and works through three tiers. The sponsor is the promoter who establishes the fund, the trustees hold the assets in trust for the unit holders and watch over the fund, and the asset management company, appointed by the trustees, actually manages the schemes and takes the investment decisions. A custodian registered with the regulator keeps the securities, and a registrar and transfer agent handles the unit holder records. Mutual funds are regulated by the Securities and Exchange Board of India under the SEBI (Mutual Funds) Regulations, 1996, and the Association of Mutual Funds in India, formed in 1995, is the industry body that frames codes of conduct and runs investor awareness work.

How the industry grew in India

The Unit Trust of India was set up in 1963 by an Act of Parliament and held a monopoly for more than twenty years; its first scheme, Unit Scheme 1964, is remembered in papers as US-64. Public sector banks and insurers were allowed to float mutual funds from 1987, the first being SBI Mutual Fund. The industry was opened to the private sector in 1993, after which the SEBI regulations of 1993 and then of 1996 put a common framework in place. In 2003 the Unit Trust of India was split into the Specified Undertaking of the Unit Trust of India and UTI Mutual Fund, which works under the SEBI regulations like any other fund.

Types of mutual fund schemes

Schemes are grouped in two ways, by structure and by what they invest in. By structure a scheme is open-ended, which an investor may enter or leave on any working day at the NAV, close-ended, which has a fixed maturity and whose units are listed on a stock exchange for trading in the meantime, or an interval scheme, which opens for transactions only in stated intervals. By asset class the categories SEBI standardised in 2017 are these.

An exchange traded fund, or ETF, is the one scheme bought and sold on a stock exchange through a broker at live prices, like a share, while an ordinary index fund is bought from the fund house at the day NAV. Both are passive: the manager only copies the index rather than picking stocks, so the expense ratio is low and the aim is to track the index, not to beat it. An equity linked savings scheme, or ELSS, is the equity scheme that qualifies for the tax deduction allowed on specified savings and carries the shortest lock-in among those options, three years.

Investing in instalments: SIP, SWP and STP

A systematic investment plan, or SIP, puts a fixed sum into a scheme at fixed intervals instead of all at once. Because the same sum buys more units when the NAV is low and fewer when it is high, the average cost per unit falls over a long period, which is called rupee cost averaging, and the investor is spared the task of timing the market. A systematic withdrawal plan does the reverse, taking out a fixed sum at fixed intervals, and a systematic transfer plan shifts money from one scheme to another in instalments, usually from a debt scheme into an equity scheme.

The other investment products, and who regulates them

An aspirant should be able to place each product with its regulator, because that is the commonest question of all.

Among the small savings instruments, the Public Provident Fund runs for fifteen years and may be extended in blocks of five, the National Savings Certificate and the Kisan Vikas Patra are fixed-term certificates, the Senior Citizens Savings Scheme is meant for those above sixty, and the Sukanya Samriddhi account is opened for a girl child before she turns ten and matures twenty-one years from the date it was opened. Their interest rates are notified by the government every quarter, so an aspirant should learn the design of each scheme rather than a rate. Gold may be held as a gold exchange traded fund, and sovereign gold bonds issued by the Reserve Bank on behalf of the Government of India carry an eight-year term with an exit allowed from the fifth year. Every mutual fund scheme also carries a risk-o-meter, the SEBI label that places the scheme on a scale from low to very high risk, and its scheme information document sets out the objective, the costs and the risks.